A Private-Equity Boost for China-wsj 4/3 : 중국 외국계 사모펀드 금융,자본시장 진입장벽의 현실적 문제점

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Bloomberg

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By SCOTT A. JALOWAYSKI

A change of leadership in Beijing brings with it speculation about a change of economic policy. There is now general agreement that the country needs to transition away from its investment-led growth model, toward a greater reliance on domestic consumption as an engine of prosperity. Yet despite bold announcements, real reform still seems far off. To see why, consider the trials and tribulations of foreign private-equity funds.

Despite a much-hyped private-equity "boom" in China, investment by foreign PE funds is stagnant. Private-equity investment in Greater China by foreign (U.S. dollar) funds has declined to about $7.5 billion as of 2011 from $14.5 billion in 2007, while Chinese PE investments by yuan funds have increased to $6.7 billion from $1.9 billion. Foreign PE funds' share of the value of total private equity investment has declined to 27% from 69%.

Those of a nationalistic bent might appreciate this shift in the PE balance in favor of domestic funds. But it is bad news for the economy as a whole. Foreign private-equity investment would help free enterprise financing from the stranglehold of banks that are still inclined to steer too much capital toward state-owned and other favored companies at the expense of more entrepreneurial ventures. This is especially important in the context of the rebalancing discussion because the companies that have the hardest time accessing capital right now are privately owned and in the domestic-facing and service industries that will provide the goods and services for Chinese to consume.

Greater foreign PE investment would also be a way to mediate capital between foreigners keen to fund China's growth and smaller Chinese businesses with potential, and to allow Chinese entrepreneurs to tap a wider pool of managerial expertise. The amount of dollar funds raised since 2005 by PE firms outside of China for investment into China is more than 400% greater the value of yuan funds that domestic Chinese firms have raised in the same period. Beijing is leaving most of that foreign money on the table, and it's going to Japan, Southeast Asia and Australasia.

The problem is that Beijing has implemented several regulations during the past decade that have effectively cut off the economy from this useful source of investment capital. One of the highest hurdles is the Mergers and Acquisitions Rules promulgated in 2006.

The 2006 rules reiterate that all acquisitions of Chinese companies require approval from the Ministry of Commerce. This system—which had long been on the books in various forms—deters foreign PE investors because it adds a layer of regulatory complexity to each deal. An additional barrier imposed under the 2006 rules shut off the main method by which Chinese entrepreneurs and foreign investors had worked around the rules: so-called round-trip investment.

Throughout the 1990s and early 2000s, private-sector Chinese entrepreneurs could set up offshore ownership structures in Hong Kong, the U.S. or the Cayman Islands, that through a new Chinese subsidiary would acquire operating business assets in China. This allowed the new business, once local-government approval was obtained in China, to accept foreign private-equity money invested into the overseas holding company, while abiding by the letter of Beijing's restrictions on foreign investment in domestic enterprises. Some of China's most successful companies, including NetEase and Baidu, received foreign capital this way.

The 2006 rules marked an attempt to assert Beijing's authority to approve offshore transactions as if they were occurring onshore, introducing a new requirement to obtain approval for the round-trip investment from the Ministry of Commerce. But this was a move in the wrong direction. Instead of exporting domestic restrictions offshore, Beijing should have liberalized or eliminated the onshore approval process. To date, the Ministry of Commerce has yet to grant a single round-trip investment approval under the 2006 rules.

The past few years have demonstrated how inefficient these and other restrictions are, at the expense of both foreign PE investors and privately owned domestic enterprises. The first and most obvious impact is dwindling competition among private-equity investors. Domestic funds are enjoying a renaissance at the moment because whereas foreign PE funds face a cumbersome approval process, local funds don't require any such approvals.

This irritates the foreign funds, but it also costs Chinese companies receiving investments. Where once those entrepreneurs enjoyed a choice of private-equity firms with which to partner—and might have chosen based on industry expertise, or a PE firm's track record—now their choices are limited. So is the amount of PE capital available, despite the rapid growth of domestic funds. This is playing out now as inexperienced yuan-fund sponsors are demanding exits—favoring short-term profits over building sustainable enterprises.

Private equity doesn't often show up on the to-do lists economists propose for Beijing as leaders trying to effect a transition to domestic consumption. But it speaks to the key challenge facing China: how to re-allocate capital toward uses that will generate sustainable growth. To get it right, leaders must allow dollar-denominated private equity funds back into the game on equal terms.

Mr. Jalowayski is a partner in the private equity and M&A practice of Ropes & Gray LLP.